In 2008, Bailouts for Everyone! Fannie Mae, Freddie Mac, AIG Insurance, TARP, etc., But Mainly for Citigroup (Again!)

Many Americans may remember the fall of 2008 as a chaotic and frightening series of teetering dominoes—huge financial firms that had bet too much on the housing market. Many Americans may also recall experiencing a tremendous anger as the government rescued one stumbling giant after another. In September, Washington bailed out the government-created mortgage investors Fannie Mae and Freddie Mac. Then the feds rescued the insurance titan AIG, effectively a bailout of all the Wall Street firms to which AIG owed money. Among the great financial houses, only Lehman Brothers was allowed to fail.

But the Lehman moment of market discipline didn’t last long. The government then came to the rescue of money market mutual funds and issuers of commercial paper. By early October, President George W. Bush had signed the Emergency Economic Stabilization Act into law, creating the $700 billion Troubled Asset Relief Program. Roughly ten days later, financial regulators began spending this pot of rescue money, announcing direct investments in America’s largest banks. But was there one bank in particular that had regulators scared enough to engage in such radical interventions in the economy?

In the fall of 2008, few people in America had access to more information about the health of American financial institutions than FDIC chairman Sheila Bair. Four years later, she looked back on that season of crisis and wrote: “I frequently wonder whether, if Citi had not been in trouble, we would have had those massive bailout programs. So many decisions were made through the prism of that one institution’s needs.”

—James Freeman and Vern McKinley, Borrowed Time: Two Centuries of Booms, Busts and Bailouts at Citi (New York: HarperCollins, 2018), e-book.

Different Credit Expansion Channels Do Not Affect the Basic Mechanism of the Business Cycle But Cause Differences in the Secondary Features of the Cycle

These different credit expansion channels do not affect the basic mechanism of the business cycle (characterized by erroneous investments as a result of the artificially lowered interest rate) but are responsible for the differences in the so-called secondary features of business cycles that make them nonidentical despite obvious similarities.

Finally, it is worth noting that the course of the business cycle and the implementation of the Cantillon effect are influenced not only by the investment policy of commercial banks, but also by other factors. I mention a few of them here. First of all, central banks may conduct monetary policy in various ways and create a monetary base, which has varied effects on credit expansion and, consequently, on the course of the business cycle. For example, quantitative easing is a different mechanism of introducing new money into the economy, relative to traditional open market operations, generating a slightly different first-round effect. While in the open market operations the most frequently purchased debt instruments are short-term Treasury bonds, quantitative easing may take place through also buying long-term bonds, including non-treasury bonds (e.g. corporate bonds or bonds secured by mortgages). This entails different redistributive effects, also affecting the yield curve and the risk premium in different ways.

Second, the type of entity that creates new money through the credit market and the way it is created is also important for the course of the business cycle and the implementation of the accompanying Cantillon effect. At present, a significant portion of loans are granted for the purpose of converting them into securities or, in general, by entities other than commercial banks. Indeed, banking activity has changed significantly in recent years and banks have largely abandoned traditional commercial banking based on taking deposits and lending, and instead adopted a business model based on loan securitization and their distribution to the so-called shadow banks. The effects of increasing the money supply (in the form of credit) vary, therefore, depending on what type of bank (rural or urban, small or large) or institution provides the loan. Loans can be created not only by commercial banks. Other depository institutions (such as savings banks or credit unions) and the so-called shadow banking system also participate in this. The creation of money by shadow banks seems particularly important in the modern economy, because securitization enables traditional commercial banks to increase lending (including through transfer of credit risk outside the bank balance sheets to investors purchasing securities), and intermediation of liabilities allows the so-called shadow banks to create loans by themselves. The creation of a loan through a shadow banking system implies a different implementation of the Cantillon effect, because the shadow banks’ asset structure differs from the structure of traditional banks’ assets, and certain types of loans are more readily used in the securitization process.

—Arkadiusz Sieroń, Money, Inflation and Business Cycles: The Cantillon Effect and the Economy, trans. Martin Turnau, Routledge International Studies in Money and Banking (Milton Park, UK: Routledge, 2019), 91-92.

At the Heart of the Credit Crisis Is the Network of Highly-Leveraged Off-Balance-Sheet Vehicles—the Shadow Banking System

Pozsar’s initial paper outlined the “constellation of forces that drove the emergence of the network of highly-leveraged off-balance-sheet vehicles—the shadow banking system—that is at the heart of the credit crisis.”

Off-balance sheet (OBS) is an accounting maneuver used by companies to reduce their debt levels for reporting purposes. Enron perfected the use of OBS partnerships to hide its true liabilities from regulators and shareholders. Many at the Fed believed the OBS demon had been forever exorcized with Enron’s fall. But the demon had grown and metastasized, spreading little cancers throughout the financial system.

The resurrection of OBS vehicles had been made possible because banking had been reshaped by deregulation, innovation, and competition. Then the Fed lowered interest rates, creating “an abundance of credit for borrowers and a scarcity of yield for investors.” (Thank you, Alan Greenspan!)

Pozsar pinpointed the 1988 Basel I Accord as the main catalyst for the growth and advances of “credit risk transfer instruments” like CDOs [Collateralized Debt Obligations], MBSs [Mortgage-Backed Securities], asset-backed securities (ABS), asset-backed commercial paper (ABCP), commercial mortgage-backed securities (CMBS), and so on.

Issued after the banking crises of the late 1980s, the new Basel rules required that banks meet a minimum capital requirement and hold even more against riskier assets. For investment bankers seeking to maximize profits, and thus their own compensation, the changes created the need to hide liabilities in the shadows.

—Danielle DiMartino Booth, Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America (New York: Portfolio Penguin, 2017), e-book.

In September 2007, Northern Rock Triggering the First High Street Bank Run in the UK Since 1866

The British bank Northern Rock played a starring role in the unfolding drama of the financial crisis. In September 2007, news that Northern Rock had used emergency liquidity support from the Bank of England led to the first high street bank run in the United Kingdom since Overend, Gurney and Co. in 1866. Following unsuccessful attempts at finding a private-sector buyer, Northern Rock was nationalized in February 2008, a policy outcome that would have struck many people as unthinkable just a few months before. Indeed, the speed at which “the Rock” had gone from being the darling of the city to a symbol of the meltdown was breathtaking. Following its listing on the FTSE 100 in 2000, the share price had been steadily increasing, and the company posted profits of more than £440 million in 2006. Around 5 percent of annual profit was being paid into the Northern Rock Foundation, which grew to be one of the United Kingdom’s largest corporation foundations (giving grants of more than £27 million in 2006), and the company had emerged as a beacon of North East economic renewal through its sponsorship of local sports teams and the planned development of new headquarters. If loyal customers were surprised at the speed of the bank’s downfall, they weren’t alone.

The main problem with Northern Rock’s business model was that its rapid expansion entailed two things: (1) allowing mortgage products to constitute a high proportion of its assets (about 75 percent) and (2) funding this through wholesale markets. [Note that unlike the situation facing many US banks, it wasn’t an increase in defaults on mortgage payments that got Northern Rock into trouble but the freezing up of funding.]  In hindsight, the errors seem obvious, but the board was so oblivious that it planned a 30-percent increase in dividends as late as July 2007. And yet just two months after making a voluntary choice to reduce capital, it required emergency liquidity provisions. When questioned about this decision, Adam Applegarth (then CEO) pointed out that it wasn’t only the board that failed to anticipate the problem; the company had been focused on compliance with the Basel II international standards, working alongside the Financial Services Authority (FSA). Indeed, regulators deserve blame for two elements of this. First, the regulations themselves encouraged aspects of the problem: “Mortgage products had been made so attractive by IRB [internal-ratings-based] adherence to Basel II, that there was an incentive to grow them more quickly than could be funded by depositors.” There is little reason to think that stoking a housing bubble was an aim of Basel II, suggesting that it was an unintended consequence, that the Basel committee was simply ignorant of the activity that it was encouraging. The second failure of regulators was in not identifying the problems after they had begun to emerge. In June 2007, the FSA had approved the approach taken by Northern Rock to satisfy Basel II, partly because “they had Tier 1 capital of a ‘healthy’ 11.3 per cent of RAW [risk-weighted assets].” Despite retrospective protestations, the FSA was hardly trying to rein in a reckless company.


—Anthony J. Evans, “The Financial Crisis in the United Kingdom: Uncertainty, Calculation, and Error,” in The Oxford Handbook of Austrian Economics, ed. Peter J. Boettke and Christopher J. Coyne (New York: Oxford University Press, 2015), 749-750.

With the 2007–2008 Crisis, the Instabilities Arising from Maturity Mismatches Appeared in New and Hidden Forms Such as Mortgage-Backed Securities

Austrian economics provides fundamental but too often ignored insights into the challenges of monetary and macroeconomic policymaking. The Austrian theory of the business cycle offers a persuasive account of the genesis of the 2007–2008 crisis: it was made possible by the reliance of central banks worldwide on the reduction of short-term rates of interest to promote private sector spending. This encouraged an unsustainable expansion of money and credit. The only substantive difference from previous financial crises, something that allowed the preceding credit boom to proceed for so far and so long, was that instabilities arising from maturity mismatches appeared in new and therefore hidden variants, through money market funding of mortgage-backed securities and other structured credit assets. Austrian economics also provides a valuable explanation of previous episodes of global economic instability, for example the breakdown in the early 1970s of the post-war Bretton-Woods fixed exchange rate system based on a gold exchange standard as a consequence of insufficient discipline on US monetary creation.

Austrian economics is also the only free-market orientated school of thought drawing full attention to the deficiencies of the global policy response since 2007–2008. Central banks and governments around the world have mitigated the impact of the crisis on output and employment, providing more than $10 trillion dollars of financial support to prevent bank failures, cutting short-term interest rates for all the major currencies close to zero and engaging in a sustained and aggressive fiscal expansion that has more than doubled the ratio of public sector debt to GDP.

These measures may have been effective short-term palliatives, but they have done little to deal with underlying causes. While substantial increases in regulatory capital requirements and a wide range of other regulations have reduced tax-payer exposure to banking risks, investors have been left in little doubt that they will be protected once again should the entire financial system once again be threatened. The resumption of growth in the advanced economies is based as before on credit creation and maturity mismatch. The mispricing of assets and misallocations of capital evident before the crisis have continued, in many cases becoming even more marked. Economic expansion has been much stronger than was generally expected in the 18 months following the collapse of Lehman brothers, but this recovery has not been strong enough to allow a winding down of fiscal expansion. A policy of temporary ‘pump priming’ has turned into a policy of permanent and unsustainable fiscal deficits.

—Alistair Milne, “Cryptocurrencies from an Austrian Perspective,” in Banking and Monetary Policy from the Perspective of Austrian Economics, ed. Annette Godart-van der Kroon and Patrik Vonlanthen (Cham, CH: Springer International Publishing, 2018), 223-224.

Since Credit Default Swaps Can Be Used to Take Down Banks, They Can Be a Financial Weapon of Mass Destruction

Icelandic banks had no difficulties as long as international liquidity was ample and they could easily renew their short-term foreign-denominated debts. In early 2006, however, problems in the interbank market surfaced, in what would later be called the “Geyser crisis.” Price inflation increased and the króna depreciated as foreign money started getting nervous about the sustainability of the Icelandic boom. . . .

A vicious spiral may set in. Rising spreads indicate the market’s distrust of the banks, spurring even further demand for insurance, leading to even higher spreads on the debt, and so on, until the distrust in the bank reaches a point where the bank cannot receive further funding and it fails. Due to this self-reinforcing spiral of distrust and rising bank funding costs, reputable investors, commentators, and economists (most notably Warren Buffet), have called CDS [Credit Default Swaps]  instruments weapons of mass destruction. Indeed, CDSs can be used to take banks down by lowering the confidence in them. Yet they can only work if banks are vulnerable; that is, if they violate the golden rule of banking and mismatch maturities, or they mismatch currencies, or they do both. Only then will the distrust translate into funding problems that threaten the bank’s liquidity and eventually its solvency. When the bank matches maturities and currencies and holds 100 percent reserves to cover its deposits, the distrust may lead to a loss of consumers as some depositors do not continue rolling their funding over; that is, they withdraw their deposits. This, however, will not take down the bank, as no liquidity loss will result. Only a mismatch makes the banks vulnerable to this type of failure.

—Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 73-74.

Hedge Funds Could Bet on the Downfall of Icelandic Banks by Buying Credit Default Swaps

Credit default swaps written on Icelandic banks soared. A credit default swap (CDS) is a form of insurance that investors buy to compensate for a loss if a particular debtor defaults on its obligation. Thus, when an investor holds a million-dollar bond issued by Glitnir and the insurance premium is twenty-five basis points or 0.25 percent, he can insure himself against a default by paying an annual fee of 0.25 percent of one million, i.e., $2,500. An intriguing aspect of credit default swaps is that you may buy them even though you do not own any debt issued by the company, Glitnir in this example. Lacking ownership in the underlying company, you are just betting that Glitnir will default on its obligation. By paying just $2,500 a hedge fund could make a gross profit $1 million if Glitnir defaulted on its obligations. Funds could bet on the downfall of Icelandic banks by buying credit default swaps, and by the very act of buying the swaps they could hope to undermine confidence in the banks and promote their own investment. The CDS spread on a bond is like an insurance premium in that it indicates the confidence in the bond. At the beginning of 2006 investors started to bet against Icelandic banks because of the banks’ high dependence on wholesale short-term funding and their burgeoning size, which made them too big to be bailed out by the Icelandic government. As foreign investors increased their demand for protection against defaults by Icelandic banks, the price of the insurance increased in CDS markets; that is, spreads on the banks rose.

—Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 73-74.

A Price Deflation Might Bring Down a Fractional Reserve Banking System as the Real Burden of Debt Increases

A price deflation might bring down a fractional reserve banking system. This is so, because a price deflation can lead to bankruptcies as the real burden of debt increases. Especially in a recession after an artificial boom, a credit contraction and bankruptcies due to the malinvestments occurs. As a consequence of the bankruptcies that are induced by the price deflation, loans that banks gave out will turn bad. The stocks of the bankrupt companies that other banks hold will lose value, perhaps even to the point of becoming worthless. In general, the assets of banks will fall in value. In order to preserve solvency banks will restrict credits and put pressure on its corporate partners and other banks. The decline in one bank’s assets’ values might induce doubts in the solvency and liquidity of other banks. Due to the credit restriction, corporate partners might go bankrupt. Other banks also financing these corporations get into financial difficulty as well. Bank runs might occur. In a fractional reserve system, by definition, the bank cannot pay out all demand deposit claims that exist. The bank will go bankrupt. If one bank collapses this instability might spread to other fractional reserve banks due to their interconnectedness. The bankruptcy will induce fear about the solvency of other banks, further reduce the value of their assets’ value, and lead to systematic bank runs. A bank panic ensues. This might bring the whole fractional reserve banking system down if the central bank fails to bail out the banking system. This possible consequence of price deflation is beneficial as it purges the old banking system making place for a 100% gold standard as Rothbard points out.

—Philipp Bagus, In Defense of Deflation, Financial and Monetary Policy Studies 41 (Cham, CH: Springer International, 2015), 90.

The Boom in Residential Real Estate in Toronto, Vancouver, and Sydney Far Outside the Commodity Producing Regions

These housing market issues become of particular relevance to small- and medium-sized economies under the regime of the 2% inflation standard.

The governments/central banks here face a particular dilemma, especially if there is an attractive narrative which could buoy speculative interest (carry trades) in their national currency. For example, a range of commodity producing and/or emerging market economies have found themselves during the present asset price inflation episode encountering huge demand for their still-positive interest rate monies. That narrative is sometimes rapid growth potential. And a sequence of capital gains on the related currency carry trade imparts positive feedback loops to still more participation in that. . . .

In the great asset price inflation of the present decade, policy-makers in a range of small- or medium-sized countries rejected following the defiant path of hard money. For example, Canada and Australia found their currencies under tremendous upward pressure in the first stage of the US monetary inflation as dollar depreciation and the China monetary boom drove the prices of their key commodity exports towards the sky. The central banks of both Commonwealth countries took the same tack—not allowing interest rates to rise in line with economic expansion fed by commodity export boom so as to contain the strength of their currencies. The result: a boom in residential real estate in the star cities (Sydney, Toronto and Vancouver) far outside the commodity producing regions. A lead narrative featured the flood of newly rich Chinese investors and occupiers of these. And though low, the interest rates had sparkled to a range of income-famished investors in the world outside, including European central banks and other sovereign wealth funds diversifying into these still-positive interest rate monies. Another feature of the monetary policies followed was the build-up of a consumer debt boom, in part taking advantage of the raised value of real estate collateral.

—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 140-142.

The Mercantilist Idea that Increasing the Money Supply Increases Prosperity Was Exposed as an Error Centuries Ago by Richard Cantillon

We now turn our attention to what happens with an increase in the money supply, rather than an increase in savings. This is critically important. The mercantilist idea that increasing the money supply increases prosperity was exposed as an error centuries ago by Richard Cantillon. However, modern mainstream economists, including the monetarists, Keynesians of various sorts, and the now-fashionable market monetarists, fully embrace the idea that printing money is necessary for prosperity.

In fact, the major central banks of the world have embarked on an unprecedented policy of monetary expansion both before and after the financial crisis of 2008. These central banks are led by people with advanced degrees in “economics,” and they have large research staffs of people with PhDs in mainstream economics. The result is a world currency war whereby each currency is printed in an effort to implement an economic expansion by a beggar-thy-neighbor policy, another widely discredited idea.

The beggar-thy-neighbor policy involves printing money to reduce the value of your domestic currency vs. foreign currencies. Reducing the value of your currency reduces the relative price of your exports and makes foreign products relatively more expensive so that you increase exports and domestically produced goods and reduce imports. Th e problem is that you also increase the price of imports and decrease efficiency. Ultimately this policy does not work: in the end you are worse off .

—Mark Thornton, The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century (Auburn, AL: Mises Institute, 2018), 59-60.

The Sovereign Debt Crisis in the European Monetary Union in 2010—12/13 Triggered Huge Demand for the Swiss Franc as Safe Haven

Both countries (Canada and Australia) remained loyal and committed members of the 2% inflation standard. And so did that once hard money country Switzerland. In the 1990s it slowly drifted away from its monetarist past and adopted an inflation-targeting regime, albeit not so laser fixated on 2% as was more broadly the case. The sovereign debt crisis within the European Monetary Union in 2010—12/13 triggered huge demand for the Swiss franc as safe haven, to which the Swiss authorities responded by massive foreign exchange market intervention, a spell of  fixing a ceiling to the currency, and ultimately a journey into an emergency negative interest rate regime which persisted for years. The big difference from the Australian and Canadian experiences was the massive foreign exchange market intervention and the adoption of radical monetary-easing measures—perhaps indicative of an even greater potential “overshoot” of the currency which might have occurred if the Swiss had held their hard money ground.

—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 142-143.

Japan Is the Battleground for Monetary Theorists; The Architects of the 2% Inflation Standard Can View Japan as a Laboratory Where the Most Powerful Non-Conventional Tools Have Been Deployed

And in looking further back, to before the journey started, the huge scope of the Japanese bubble and bubble economy in the late 1980s is a challenge to any serious purveyor of monetary or broader economic theory. Can this theory explain what happened and what went wrong in Japan? Our examination should also test any such theory in the story of Japanese deflation (itself largely myth rather than fact). The battle has been joined by sound money theorists drawing on Austrian School economics, who argue that Japan’s and indeed the globe’s economic outcome would have been much better if in fact there had been some period of declining prices.

We could describe Japan as the battleground for monetary theorists. The architects of the 2% inflation standard can view Japan as a laboratory where in recent years the most powerful non-conventional tools yet have been deployed. The Abe government was victorious in the political arena in terms of taking Japan on to the 2% inflation standard and in authorizing such tools. And at the time of writing, the world is basking in a stock market boom and global economic upturn in which Japan is fully sharing. Its apparent successes could be pyrrhic if indeed Japan adds to the evidence that the 2% global inflation standard is harmful to prosperity.

—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 96.

The Reserve Bank of New Zealand Led the Way to Formal Inflation Targeting Followed by the Bank of Canada, the Bank of England, and the Reserve Bank of Australia

A tiny country on the southern edge of the earth, New Zealand, led the way into formal inflation targeting, followed soon by Canada and the UK. Additionally New Zealand had a connection to a central part of the neo-Keynesian doctrine that featured backstage to inflation targeting—the so-called Phillips curve (an empirical relationship between inflation and unemployment which had its origin in the work of a once New Zealand war hero, later a professor at the London School of Economics). The inflation targets as determined by these countries were very much improvised and set by governments seeking to keep their central banks on course to lowering inflation rather than growing out of a considered economic blueprint for a new experiment in fiat money stabilization. Work on that had been going on for many years within the economics profession as we shall see—but the implementation of an inflation-targeting regime in a large economy was still some time away.

Specifically, in the New Zealand launch, the impetus came from a finance minister keen to make the central bank accountable in a transparent way for its actions—with the action plan to bring inflation down from a then high level (around 5%). In 1989 the Reserve Bank of New Zealand Act came into force. The Act established the operational independence of the Reserve Bank in respect of monetary policy and specified price stability as the single monetary policy objective. Simultaneously the Minister of finance and the governor signed the first Policy Targets Agreement which specified an annual inflation target of 0–2%. (3–5% target for 1990, with a gradual reduction into the 0–2% range by 1992 (changed to 1993).

Canada followed New Zealand. In February 1991 a joint announcement by the minister of finance and the governor of the Bank of Canada established formal inflation targets. The target ranges were 2–4% by the end of 1992 and 1.5–3.5% by December 1995. Subsequently the range was lowered to 1–3%. The Bank of Canada is not directly accountable to the government via formal sanctions if it misses its targets as in New Zealand but rather like the Reserve Bank of Australia is accountable to the public in general.

The UK was the next country to adopt formal inflation targeting, following that country’s exit from ERM in October 1992. The government set the target (initially 1–4%) and invited the governor of the Bank of England to begin producing an Inflation Report on a regular quarterly basis which would report on the progress being made in achieving the target. At the time of adoption, inflation was at 4%. The British inflation-targeting regime was similar in flexibility to the Canadian framework (and Australian which started around this same time).

—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 13-14.

Most Germans Wanted Hard Money Because a Single Generation Had Lost Its Monetary Savings Twice: In the Hyperinflation of 1923 and in the Currency Reform of 1948

The EMS [European Monetary System] tried to fix exchange rates that had been allowed to float in a corridor of ±2.25 percent around the official rate. But the intention of fixed exchange rates was incompatible with the system built to achieve that aim. The idea was that when the exchange rate would threaten to leave the corridor, central banks would intervene to bring the rate back into the corridor. For this to happen, a central bank would have to sell its currency, or in other words, produce more money when the currency was appreciating and moving above the corridor. It would have to buy its currency, selling assets such as foreign exchange reserves, if its currency was depreciating, falling below the corridor.

The Spanish Central Bank provides us with a good example. If the peseta appreciated too much in relation to the Deutschmark, the Bank of Spain had to inflate and produce pesetas to bring the peseta's price down. The central bank was probably very happy to do so. As it could produce pesetas without limits, nothing could stop the Bank of Spain from preventing an appreciation of the peseta. However, if the peseta depreciated against the Deutschmark, the Bank of Spain would have to buy its currency and sell its Deutschmark reserves or other assets, thereby propping up the exchange rate. This could not be done without limits, but was strictly limited to the reserves of the Bank of Spain. This was the basic misconstruction of the EMS and the reason it could not work. It was not possible to force another central bank to cooperate, i.e., to force the Bundesbank to buy peseta with newly produced Deutschmarks when the peseta was depreciating. In fact, the absence of such an obligation was a result of the resistance of the Bundesbank. France called for a course of required action that would reduce the independence of the Bundesbank. Bundesbank president Otmar Emminger resisted being obliged to intervene on part of falling currencies in the EMS. He finally got his way and the permission from Helmut Schmidt to suspend interventions leading to the purchase of foreign currencies within the EMS agreements. Countries with falling currencies had to support their currencies themselves.

Indeed, an obligation to intervene in favor of falling currencies would have created perverse incentives. A central bank that inflated rapidly would have forced others to follow. Fiat paper currencies are introduced for redistribution within a country. Fixed fiat exchange rates coupled with an obligation to intervene allowed for redistribution between countries. In such a setup, the faster inflating central bank (Bank of Spain) would force another central bank (Bundesbank) to follow and buy up faster, inflating one’s currency. The Bank of Spain could produce pesetas that would be exchanged into Deutschmarks buying German goods. Later the Bundesbank would have to produce Deutschmarks to buy peseta and stabilize the exchange rate. There would be a redistribution from the slower-inflating central bank to the faster-inflating central bank.

Yet, in the EMS there was no obligation to buy the faster-inflating currency. This implied also that the EMS could not fulfil its purpose of guaranteeing stable exchange rates. Fixed fiat exchange rates are impossible to guarantee when participating central banks are independent. Governments wanted both fiat money production for redistributive internal reasons and stable exchange rates. This desire makes voluntary cooperation in the pace of inflation necessary. Without voluntary cooperation, coordinated inflation is impossible. The Bundesbank was usually the spoilsport of coordinated inflation. It did not inflate fast enough when other central banks, such as the Bank of Italy, inflated the money supply to finance Italian public deficits.

The Bundesbank did not inflate as much on account of German monetary history. A single generation had lost almost all monetary savings two times, namely, after two world wars: in the hyperinflation of 1923 and the currency reform in 1948. Most Germans wanted hard money, and expressed that through the institutional set up of the Bundesbank, which was relatively independent of the government. What all of this means is that, in practice, the EMS would only function if central banks were only able to inflate as much as the slowest links in the chain: the Bundesbank and its traditional ally, De Nederlandsche Bank.

—Philipp Bagus, The Tragedy of the Euro, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2012), 24-26.

Another Way of Looking at the Essential and Inherent Unsoundness of Fractional Reserve Banking Is to Look at the Maturity Mismatching Problem, A Violation of the “Golden Rule of Banking”

Another way of looking at the essential and inherent unsoundness of fractional reserve banking is to note a crucial rule of sound financial management—one that is observed everywhere except in the banking business. Namely, that the time structure of the firm’s assets should be no longer than the time structure of its liabilities. In short, suppose that a firm has a note of $1 million due to creditors next January 1, and $5 million due the following January 1. If it knows what is good for it, it will arrange to have assets of the same amount falling due on these dates or a bit earlier. That is, it will have $1 million coming due to it before or on January 1, and $5 million by the year following. Its time structure of assets is no longer, and preferably a bit shorter, than its liabilities coming due. But deposit banks do not and cannot observe this rule. On the contrary, its liabilities—its warehouse receipts—are due instantly, on demand, while its outstanding loans to debtors are inevitably available only after some time period, short or long as the case may be. A bank’s assets are always “longer” than its liabilities, which are instantaneous. Put another way, a bank is always inherently bankrupt, and would actually become so if its depositors all woke up to the fact that the money they believe to be available on demand is actually not there.

—Murray N. Rothbard, The Mystery of Banking, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2008), 98-99.

According to Ludwig von Mises, the Standard Textbook Equation of Exchange, MV = PT, Is a Superficial and Unsatisfactory Theory of the Purchasing Power of Money

One of the main contributions of Mises’s TMC [The Theory of Money and Credit] is his trenchant criticism of the classical equation of exchange MV = PT. This equation, however, is still used today in every standard textbook—what is more, it is often the only formulation of the quantitative theory of money that is offered to students. The criticism by Mises is clearly unknown to the current writers belonging to the “orthodox” paradigm. This is unfortunate because Mises has convincingly shown that the equation of exchange is a superficial and ultimately unsatisfactory theory of the purchasing power of money. His main criticism is aimed at the concept of velocity of money: counting how many times a unit of money changes hands on average in a year cannot replace the concept of the subjective demand for money. The velocity of money is only a manifestation of the effects of the demand for money, and it obfuscates the causal processes through which the value of money is determined. The concept of the subjective demand for money is, as we have seen in the previous section, the necessary foundation for an explanation of the PPM. Mankiw (2011) and Milton Friedman (in his entry “Quantity Theory of Money” in the New Palgrave) both recognize this fact. They begin their respective presentations of the quantity theory with the subjectivist theory expounded above, but then they fall back and focus on the holistic and mathematical equation only.

—Renaud Fillieule, “The Monetary Theory in Current Textbooks in Light of The Theory of Money and Credit,” in Theory of Money and Fiduciary Media: Essays in Celebration of the Centennial, ed. Jörg Guido Hülsmann (Auburn, AL: Ludwig von Mises Institute, 2012), 256.

In 1913 Ludwig von Mises Warned That There Is a Serious Danger for the Future of the Individualistic Organization of the Economy in the Development of Fiduciary Media

As I have explained elsewhere, there is a serious danger for the future of the individualistic organization of the economy in the development of fiduciary media; if the legislature does not put some obstacle in the way of its expansion, an unrestrained inflation could easily come about, the destructive effects of which cannot really be imagined. Even if we ignore this, as yet, not immediate threat, there is sufficient risk from the very nature of the system of fiduciary media. We have already mentioned that it would be desirable to put an end to the artificial expansion of fiduciary media. It would not only slow down the rate of devaluation, but it would also be the best way of preventing economic crises.

Mises defined “money substitutes” as claims to a commodity money such as gold in the form of banknotes or checks that are readily and generally accepted in transactions and that are believed to be fully redeemable on demand at the banking institution that has issued them. Mises distinguished between money substitutes that are backed 100 percent by commodity money reserves at the issuing institution (“money certificates”) and those money substitutes issued by a bank that are less than fully backed (“fiduciary media”). Loans extended on the basis of 100 percent reserve backing were referred to as “commodity credit” and those loans extended on the basis of less than 100 percent reserve backing were called “circulation credit.” Mises argued that it was the extension of fiduciary media not covered by 100 percent reserves that was the source of business cycles, in that it created the illusion of more savings available in society (in the form of money loans extended through the banking system) to support and sustain investment and capital formation than really existed.

—Ludwig von Mises, “The General Rise in Prices in the Light of Economic Theory,” in Selected Writings of Ludwig von Mises, vol. 1, Monetary and Economic Policy Problems Before, During, and After the Great War, ed. Richard M. Ebeling (Indianapolis: Liberty Fund, 2012), 155, 135n5.

European Politicians Introduced the “Stability and Growth Pact” (SGP) in 1997 in order to “Manage the Commons”; However, the Regulation of the Commons Failed

These tragic incentives stem from the unique institutional setup in the EMU [European Monetary Union]: one central bank. These incentives were not unknown when the EMU was planned. The Treaty of Maastricht (Treaty on the European Union), in fact, adopted a no-bailout principle (Article 104b) that states that there will be no bailout in case of fiscal crisis of member states. Along with the no bailout clause came the independence of the ECB. This was to ensure that the central bank would not be used for a bailout.

But political interests and the will to go on with the Euro project have proven stronger than the paper on which the no bailout clause has been written. Moreover, the independence of the ECB [European Central Bank] does not guarantee that it will not assist a bailout. In fact and as we have seen, the ECB is supporting all governments continuously by accepting their government bonds in its lending operation. It does not matter that it is forbidden for the ECB to buy bonds from governments directly. With the mechanism of accepting bonds as collateral it can finance governments equally well.

There was another attempt to curb the perverse incentives of incurring in excessive deficits. Politicians introduced “managed commons” regulations to reduce the external effects of the tragedy of the commons. The Stability and Growth Pact (SGP) was adopted in 1997 to limit the tragedy in response to German pressure. The pact permits certain “quotas,” similar to fishing quotas, for the exploitation of the common central bank. The quota sets limits to the exploitation in that deficits are not allowed to exceed three percent of the GDP and total government debt not sixty percent of the GDP. If these limits had been enforced, the incentive would have been to always be at the maximum of the three percent deficit financed indirectly by the ECB. Countries with a three percent deficit would partially externalize their costs on countries with lower deficits.

However, the regulation of the commons failed. The main problem is that the SGP is an agreement of independent states without credible enforcement. Fishing quotas may be enforced by a particular state. But inflation and deficit quotas of independent states are more difficult to enforce. Automatic sanctions, as initially proposed by the German government, were not included in the SGP. Even though countries violated the limits, warnings were issued, but penalties were never enforced. Politically influential countries such as France and Germany, which could have defended the SGP, violated its provisions by having more than three percent deficits from 2003 onward. With a larger number of votes, they and other countries could prevent the imposition of penalties. Consequently, the SGP was a total failure. It could not close the Pandora’s Box of a tragedy of the commons. For 2010, all but one member state are expected to violate the three percent maximum limit on deficits. The general European debt ratio to GDP is eighty-eight percent.

—Philipp Bagus, The Tragedy of the Euro, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2012), 108-110.

The Theory of the “Tragedy of the Commons” Should Be Applied to Fractional-Reserve Banking Since the Expansive Process Derives from a Privilege Against Property Rights

We first had the opportunity to defend the thesis that the theory of the “tragedy of the commons” should be applied to fractional-reserve banking at the Regional Meeting of the Mont-Pèlerin Society which took place in Rio de Janeiro, September 5–8, 1993. There we pointed out that the typical “tragedy of the commons” clearly applies to banking, given that the entire expansive process derives from a privilege against property rights, since each bank entirely internalizes the benefits of expanding its credit while letting the other banks and the whole economic system share the corresponding costs. Moreover, an interbank clearing mechanism within a free banking system may thwart individual, isolated attempts at expansion, but it is useless if all banks, moved by the desire for profit in a typical “tragedy of the commons” process, are more or less carried away by “optimism” in the granting of loans.

—Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stroup (Auburn, AL: Ludwig von Mises Institute, 2006), 394n.

From a Position of Military Strength, the Dominating State Will Use Its Superior Power to Enforce a Policy of Internationally Coordinated Inflation, Or Monetary Imperialism

And a similarly straightforward yet once again entirely non-Marxist explanation exists for the observation always pointed out by Marxists, that the banking and business establishment is usually among the most ardent supporters of military strength and imperial expansionism. It is not because the expansion of capitalist markets requires exploitation, but because the expansion of state protected and privileged business requires that such protection be extended also to foreign countries and that foreign competitors be hampered through non-contractual and nonproductive property acquisitions in the same way or more so than internal competition. Specifically, it supports imperialism if this promises to lead to a position of military domination of one’s own allied state over another. For then, from a position of military strength, it becomes possible to establish a system of—as one may call it—monetary imperialism. The dominating state will use its superior power to enforce a policy of internationally coordinated inflation. Its own central bank sets the pace in the process of counterfeiting, and the central banks of the dominated states are ordered to use its currency as their own reserves and inflate on top of them. This way, along with the dominating state and as the earliest receivers of the counterfeit reserve currency its associated banking and business establishment can engage in an almost costless expropriation of foreign property owners and income producers. A double layer of exploitation of a foreign state and a foreign elite on top of a national state and elite is imposed on the exploited class in the dominated territories, causing prolonged economic dependency and relative economic stagnation vis-à-vis the dominant nation. It is this—very uncapitalist—situation that characterizes the status of the United States and the U.S. dollar and that gives rise to the—correct—charge of U.S. economic exploitation and dollar imperialism.

—Hans-Hermann Hoppe, “Marxist and Austrian Class Analysis,” in The Economics and Ethics of Private Property: Studies in Political Economy and Philosophy, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2006), 135

When A King Sold Bonds Under the Gold Standard This Had No Effect on the Total Money Supply; If He Spent More, Others Would Have to Spend Less

Furthermore, constrained by a commodity money standard, monarchs were unable to "monetize" their debt. When the king sold bonds to private financiers or banks, under the gold standard this had no effect on the total money supply. If the king spent more as a consequence, others would have to spend less. Accordingly, lenders were interested. in correctly assessing the risk associated with their loans, and kings typically paid interest rates substantially above those paid by commercial borrowers.

In contrast, under the gold exchange standard with only a very indirect tie of paper money to gold, and especially under a pure fiat money regime with no tie to gold at all, government deficit financing is turned into a mere banking technicality. Currently, by selling its debt to the banking system, governments can in effect create new money to pay for their debt. When the treasury department sells bonds to the commercial banking system, the banks do not pay for these bonds out of their existing money deposits; assisted by open-market purchases by the government owned central bank, they create additional demand deposits out of thin air. The banking system does not spend less as a consequence of the government spending more. Rather, the government spends more, and the banks spend (loan) as much as before. In addition, they earn an interest return on their newly acquired bond holdings. Accordingly, there is little hesitation on the part of banks to purchase government bonds even at below market interest rates, and rising government debt and increased inflation thus goes hand in hand.

—Hans-Hermann Hoppe, Democracy: The God That Failed; The Economics and Politics of Monarchy, Democracy, and Natural Order (New Brunswick, NJ: Transaction Publishers, 2011), 60n27.

Under a Hard-Money Regime, the Money-Supply Process Is Totally Privatized; Mining, Minting, Certification and Warehousing of Money Are Undertaken by Private Firms for Profit

The defining characteristic of such a monetary system has been incisively identified by Milton Friedman. In his words, “A real, honest-to-God gold standard … would be one in which gold was literally money, and money literally gold, under which transactions would literally be made in terms either of the yellow metal itself, or of pieces of paper that were 100 per cent warehouse certificates for gold.”

Thus, under a genuine gold standard, the monetary unit is, in fact as well as in law, a unit of weight of gold. This is the case whether the monetary unit bears the name of a standard unit of weight, such as a “gram” or “ounce,” or whether it bears a special name, like “dollar” or “franc,” that designates specifically a standard weight of the commodity used as money.

While it is true that certain types of government intervention in the monetary system are consistent with the basic criterion of a genuine gold standard, it is equally true that no particular government policy is essential to the operation of this monetary standard. Indeed, as Friedman notes, “If a domestic money consists of a commodity, a pure gold standard or cowrie bead standard, the principles of monetary policy are very simple. There aren’t any. The commodity money takes care of itself.”

Under the quintessential hard-money regime, therefore, the money-supply process is totally privatized. The mining, minting, certification, and warehousing of the commodity money are undertaken by private firms competing for profits in an entirely unrestricted and unregulated market. The money supply consists of gold in various shapes and weight denominations and claims to gold, in the form of paper notes or checkable demand deposits, that are accepted in monetary transactions as a substitute for the physical commodity money. These money substitutes are literally warehouse receipts that are redeemable for gold on demand at the issuing institutions, which hold a specifically earmarked reserve of gold exactly equal in amount to their demand liabilities. Barring fraud or counterfeiting, the total supply of money in the economy is therefore always equal to the total weight of gold held in the money balances of the nonbank public and in the reserves of the banks.

—Joseph T. Salerno, “Gold Standards: True and False,” in Money: Sound and Unsound (Auburn, AL: Ludwig von Mises Institute, 2010), 356-357.

The Tragedy of the Euro Is the Incentive to Incur Higher Deficits and Make the Whole Euro Group Burden the Costs of Irresponsible Policies

The tragedy of the Euro is the incentive to incur higher deficits, issue government bonds, and make the whole Euro group burden the costs of irresponsible policies—in the form of the lower purchasing power of the Euro. With such incentives, politicians tend to run high deficits. Why pay for higher expenditures by raising unpopular taxes? Why not just issue bonds that will be purchased by the creation of new money, even if it ultimately increases prices in the whole of the EMU [European Monetary Union]? Why not externalize the costs of government spending?

The resulting moral hazard is asymmetrical. Governments of larger states would produce considerable inflationary pressure running high deficits and might be too big to be bailed out. On the contrary, governments of smaller states would not produce much inflationary pressures even if they would run high deficits because the impact of the money creation would not be important for the Eurozone as a whole. Moreover, small countries could expect to be bailed out by larger countries. It is unsurprising that the sovereign debt crisis has been worse in small countries such as Greece, Ireland and Portugal.

The tragedy of the Euro is aggravated by the typical shortsightedness of rulers in democracies: politicians tend to focus on the next election rather than the long-term effects of their policies. They use public spending and extend favors to voting factions in order to win the next election. Increasing deficits delays problems into the future and also into the other countries of the Eurozone. EMU leaders know how to externalize the costs of government spending in two dimensions: geographically and temporarily. Geographically, some of the costs are borne in the form of higher prices by the whole Eurozone. Temporarily, the problems resulting from higher deficits are possibly borne by other politicians and only in the remote future. The sovereign debt problems caused by the deficits may require spending cuts imposed by the EMU.

—Philipp Bagus, The Tragedy of the Euro, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2012), 107-108.

There Is Really No Essential Difference Between the Unlimited Power of the Democratic State and the Unlimited Power of the Autocrat

And he also stressed that democracy must not be conceived as the unlimited rule of the general will:

There is really no essential difference between the unlimited power of the democratic state and the unlimited power of the autocrat. The idea that carries away our demagogues and their supporters, the idea that the state can do whatever it wishes, and that nothing should resist the will of the sovereign people, has done more evil perhaps than the caesar-mania of degenerate princelings.

Mises concluded that “only within the framework of Liberalism does democracy fulfill a social function. Democracy without Liberalism is a hollow form.” The great danger inherent in democracy is to turn the libertarian postulate of equality before the law into the postulate of economic equality.

Here is a fertile field for the demagogue. Whoever stirs up the resentment of the poor against the rich can count on securing a big audience. Democracy creates the most favourable preliminary conditions for the development of this spirit, which is always and everywhere present, though concealed. So far all democratic states have foundered on this point. The democracy of our own time is hastening towards the same end.

—Jörg Guido Hülsmann, Mises: The Last Knight of Liberalism (Auburn, AL: Ludwig von Mises Institute, 2007), 412-413.

Society Is Purely and Solely a Continual Series of Exchanges; the Two Contracting Parties Always Both Gain; Society Is an Uninterrupted Succession of Advantages

Liberal class conflict theory emerged in a polished form in France, in the period of the Bourbon Restoration, following the defeat and final exile of Napoleon. From 1817 to 1819, two young liberals, Charles Comte and Charles Dunoyer, edited the journal Le Censeur Européen; beginning with the second volume (issue), another young liberal, Augustin Thierry, collaborated closely with them. The Censeur Européen  developed and disseminated a radical version of liberalism, one that continued to influence liberal thought up to the time of Herbert Spencer and beyond. It can be viewed as a core-constituent—and thus one of the historically defining elements—of authentic liberalism (see “Liberalism, True and False,” in the present work). In this sense, a consideration of the world-view of the Censeur group  is of great importance in helping to give shape and content to the protean concept of liberalism. Moreover, through Henri de Saint-Simon and his followers and other channels, it had an impact on socialist thought as well. Comte and Dunoyer called their doctrine Industrialisme, Industrialism.

There were several major sources of Industrialism. One was Antoine Destutt de Tracy, the last and most famous of the Idéologue school of French liberals, whose friend, Thomas Jefferson, arranged for the translation and publication of his Treatise on Political Economy in the United States before it appeared in France. Destutt de Tracy’s definition of society was crucial:

Society is purely and solely a continual series of exchanges. It is never anything else, in any epoch of its duration, from its commencement the most unformed to its greatest perfection. And this is the greatest eulogy we can give to it, for exchange is an admirable transaction, in which the two contracting parties always both gain; consequently, society is an uninterrupted succession of advantages, unceasingly renewed for all its members.

Destutt de Tracy’s position was that “commerce is society itself. . . . It is an attribute of man. . . . It is the source of all human good . . .” Commerce was a “panacea,” in the words of a student of his thought, “the world’s civilizing, rationalizing, and pacifying force.”

—Ralph Raico, “The Conflict of Classes: Liberal vs. Marxist Theories,” in Classical Liberalism and the Austrian School (Auburn, AL: Ludwig von Mises Institute, 2012), 189-190.